Detroit has been in the business papers a lot lately — and not just in bankruptcy-related news. In a less prominent but still widely read story, the New York Times zeroed in on the city’s metal warehouses a couple of weeks ago to denounce the role that a subsidiary of investment banking giant Goldman Sachs has reportedly played in inflating aluminum prices.
If you haven’t read the article yet, here’s the story in a nutshell. In 2010, Goldman bought a company called Metro International, which owns many metals warehouses in the Detroit region. Metro has been sucking in aluminum (and often paying customers incentives to store their metal there), but only allowing a trickle of it out, while charging rent for keeping the stuff in storage. This hoarding of metal has created a tightness in the local market for aluminum that has kept prices artificially high. Unsurprisingly, major aluminum buyers like Coca-Cola and Miller Coors are unhappy — and so too, argues the Times, should be consumers, who pay more than market prices every time they, say, buy a can of pop.
Those are very legitimate gripes and regulators should address them. But, as Izabella Kaminzska of the Financial Times’ Alphaville blog points out, there is a larger game at play. Before the financial crisis, Goldman did not own Metro International. And J.P. Morgan, for that matter, did not own Henry Bath, another giant warehouse operator, based in the U.K. So why did large banks suddenly take such a shine to metal warehouses?
A key motivation was the emergence, in recent years, of a significant gap between current commodity prices (spot prices) and futures prices. In the aftermath of the Great Recession, the industrial downturn around the world created large surpluses of various commodities, particularly metals. This put pressure on the spot prices of commodities. At the same time, partly spurred on by the banks’ cheerleading, investors like pension funds and university endowments continued to park some of their money in commodity markets. In doing so, they put upward pressure on futures prices. Thus, futures prices rose relative to spot.
Why would such staid investors do such a thing, you ask? As Reuters’ John Kemp has explained, pension funds were convinced that commodities (technically commodity futures) were useful for diversification, and that natural resources provided protection against the risk of high inflation at a time when many central banks around the world were trying to jump-start their economies through extraordinarily lax monetary policy. I would also add that commodity investments have been seen as a play on the economies of the so-called BRICs.
Let’s take a close look at how the game works. Say you’re a Goldman Sachs or one of its large hedge fund clients. Suppose the current price for aluminum is $2,000 a tonne and its price a year out is $2300 a tonne. What do you do? You buy the metal for $2,000 and sell it forward a year out for $2,300, naturally. As long as the price difference amounts to more than your storage and financing costs, you’re guaranteed to make money. Someone, of course, needs to be playing the role of the fool on the other side of the trade who buys metal at $2,300. That sucker would be the pension funds.
Sure enough, what seemed a golden (pardon the pun) opportunity just a few months ago, is starting to look like a liability as widespread slowdowns among emerging economies put downward pressure on commodity prices. Lots of people stand to lose lots of money.
If it’s any consolation, the wind, it seems, is finally turning for the Goldmans and J.P. Morgans of the world, too. Complaints from titans like Coca-Cola and bad press from oulets like the Times, are focusing Congress and the public’s attention on the pitfalls of banks owning commodity infrastructure. It certainly does not help that J.P. Morgan has just agreed to pay a US$410 million fine for allegedly manipulating U.S. electricity markets.
Most importantly, though, long-term investors have started to flee commodity markets — and without someone willing to overpay today for tomorrow’s metal, the hoarding strategy doesn’t work.
Andrew Hepburn is a former hedge fund researcher and commodities bear. Follow him on Twitter at: @hepburn_andrew